Company X issues £100 million of 5-year variable debt on 1 January 20X0. The rate is LIBOR-linked.

Because of its exposure to increases in interest rates, company X immediately enters into a swap to convert a floating rate to a fixed rate, with a notional principal of £100 million. Interest payment dates under the swap and under the real loan are the same. As a result, company X will pay a fixed amount of 7% in respect of the loan.

Accounting

Company X draws up balance sheets at 31 December 20X0 and 20X1. The company accounts for this as a cash flow hedge of interest rate risk, with the interest payments under the loan as the hedged item and the swap as the hedging instrument. The interest rate swap has a fair value of nil at inception.

By 31 December 20X0 interest rates have risen. As a result the swap has a fair value of £150,000. This increase in fair value is taken to a cash flow hedging reserve (CFHR) with the movement recognised through other comprehensive income (OCI). The journal entries are:

Dr

Swap Asset

£150,000

Cr

CFHR (OCI)

£150,000

In addition, during the year ended 31 December 20X0, company X receives payments under the swap of £30,000. These cash flows form part of the fair value profit on the contract.

Dr

Cash

£30,000

Cr

Interest

£30,000

By 31 December 20X1 interest rates have fallen with the result that the swap is a liability with a negative value of £50,000. The decrease of £200,000 is debited to reserves so that the cumulative amount in reserves is a debit of £50,000.

Dr

CFHR (OCI)

£200,000

Cr

Swap Asset

£200,000

In addition, during this period, company X makes payments under the swap of £10,000. These payments form part of the fair value loss on the contract for that period.

Dr

Interest

£10,000

Cr

Cash

£10,000

Effect of Disregard Regulations

Where a company has elected for regulation 9 to apply, this regulation will have effect because:

there is a hedging relationship between the derivative contract and the forecast transaction;

fair value movements on the hedged item are not brought into account for the purposes of corporation tax.

In consequence the net fair value movement of £180,000 (profit) in 20X0, and the net fair value movement of £210,000 (loss) in 20X1, are both disregarded. Regulation 9(4) then substitutes an appropriate accruals basis under which the terms of the loan and the terms of the hedge are synthesised. The appropriate accruals basis is essentially a description of hedge accounting under Old UK GAAP (excluding FRS 26). On this basis the debit will always be a fixed amount of 7% which will be brought into account as either a trading expense or a non-trading loan relationship debit.

Contracts beginning or ceasing to meet the conditions of regulation 9(1)

Regulation 9(2A) provides that where a contract begins or ceases to meet the condition of regulation 9(1) such adjustments shall be made as are just and reasonable and with regard to whether amounts would otherwise fall out of account or be taxed more than once. The example at CFM57340 gives a practical illustration of how this rule operates.